Thursday, March 1, 2012

Bid-Ask Spread

One reason for preferring highly liquid versus illiquid products is the bid-ask spread. This is a cost built into a trade when the trade is a market order. This spread also happens to be the market maker's profit for providing liquidity, whether it be a traditional specialist or a high-frequency trader taking the other side of your trade. Though I usually trade using limit orders to cut down on the spread I pay, for illiquid issues, it is really difficult to get the spread down by much if I want any timely execution.

One case I stumbled on is that of specialized ETFs. With so many specialized ETFs on the market, slicing, dicing, and grafting all different kinds of securities, some of them are bound to be too exotic to gain the trading volume of a typical S&P 500 stock. Moreover, ETF share creation and redemption mechanisms usually work to minimize costs, but this is not always the case. A case in point are the ETFs issued by brokers specifically for their own customers. Whereas SPDRS, Vanguard, and iShares ETFs trade millions of shares a day, some of these broker-tied ETFs only trade tens of thousands. These ETFs can be traded by anybody via any broker, but the customers of the issuing broker receive incentives such as commission-free trading. The price, however, is greatly reduced liquidity and large bid-ask spreads. I frequently see spreads of 0.5%+ for some of these products. For a large number of trades and a good amount (> $2000), paying the spread quickly becomes more expensive than paying a hefty commission. Large bid-ask spreads certainly aren't restricted to certain low volume equity-like products. Spreads in forex are quite lucrative for forex brokers, some of whom do not charge commission at all in favor of profiting for spreads. For currency-pairs such as the New Zealand Dollar (NZD), large spreads are quite common. In contrast, EUR-USD and JPY-USD usually maintain 1-2 pip spreads. However, during major events and announcements, even these high-volume instruments may see spreads widen considerably.

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Disclaimer: I may trade in or out of any of the above names. None of the above should be construed as investment advice. It is only for informational and entertainment purposes. Please consult a qualified financial professional before acting on any financial information.